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Debt-Equity Splits on Real Estate Deals

Could you comment generally on what the debt-equity split is normally on a real estate deal?

One of my readers has asked me this. There are many kinds of real estate deals and not every deal is the same. Therefore it is really difficult to say what "normal" is. In addition to the variety of real estate deals out there, there are many different ways to finance a deal. Creative financing is really what creative dealmaking is all about.

A typical real estate development in which a developer approaches a bank for commercial lending will usually need 20% to 30% in equity. Development loans are not like residential mortgages, they usually come in the 7 or 8 year flavor or maybe a 10 to 15 year flavor. Commercial banks know you are in the business of developing a product and that their financing is being used for that purpose. Therefore, they are going to charge you juice to use their money to make you money. If you are willing to pay a higher rate, then you may be able to get less onerous equity requirements.

You should know that a commercial lender is not like a traditional home mortgage lender. They will need to see the financials of the deal to make sure that their money is going to be used judiciously. They will need to see the
financials of the developer and will need personal guarantees on the
loan that is secured by the developer's personal assets or interests in
other projects. So in addition to equity, they need some sort of security.

You can imagine that if a well known developer has a high net worth and value of his personal securities, then that bank may not require as high of an equity requirement for the loan. However, the rules can only be bent so far. Commercial banks are federally regulated and must satisfy reserve requirements. In other words, they can only have a certain debt to equity ratio themselves - they can only lend out so much money based on their reserves according to law.

None of this really matters though if you are creative in your financing. Let's say you go to investors to raise money for your deal. They may be willing to provide the equity for the loan and therefore you don't have to put much hard equity in the deal.

Or let's say you find somebody who owns a plot of land that agrees to sell it to you and to finance the land themselves. You write a promissory note to them saying you will pay them a certain price plus accrued interest at a certain date. Then you go to the bank and use that land that you own as the equity for the commercial loan. Technically you have no equity in the deal, but on paper you have equity to get a hard money loan.

Comments

Thanks very much - this was very helpful, and exactly the information I wanted. I knew a bit about the complexity of RE deals and the possibility for creativity, but not many people tell you how much equity they need to have (other than reinforcing that the more borrowed money the better). I appreciate the clarification and the straight talk.